SuretyScore<sup style="font-size:x-small" b-7uusobzmnj>SM</sup>

Credit Risk is the primary financial risk in the banking system. Interagency standards for safety and soundness guidelines underscore the critical importance of ongoing credit risk review and communication to management and Board of Directors. Regulators require a credit risk rating system for actively managing risk at both the loan level and portfolio level.

Be sure of credit risk! A well-managed risk rating system properly differentiates risk and provides guidance for loan pricing.¹ It allows management to assess credit quality, identify problem loans, monitor changes in risk and manage risk levels.² It also gives the Board of Directors, auditors, and regulators information they can use to evaluate the overall health of the commercial portfolio and the effectiveness of financial institution management.³ Unlike consumer lending, commercial lending requires a good balance of facts and figures, intuition, and experience. SuretyScore^sm is the one tool that pulls it all together – facts, figures, stimulates good judgement, and forecasts performance.

SuretyScore^sm was developed by lenders for lenders, underwriters, and risk managers, and has proven effective on commercial credits of all sizes, big and small. Over a twelve-year period, the prototype to SuretyScore^sm was used exclusively by the author and team of lenders. Over $64 million in loans were booked between May 2011 and May 2023 – total losses were $102 thousand and the average weighted rate was Prime + 2.38%. Losses did not occur in seven of the twelve years. What makes SuretyScore^sm unique? Strengths and weaknesses are accurately defined and properly weighted to mitigate losses and reveal the likely return. Independent loan reviewers and examiners have commended the effectiveness of SuretyScore^sm time and time again.

^{1 Office of Comptroller of the Currency, Comptroller’s Handbook, 2020}

^{2 Federal Register, Vol. 84, No. 201}

^{3 NCUA Examiners Guide, 2020}

Disclaimer ↑top

While SuretyScore^sm and similar models have been used successfully to identify credit risk and price credits commensurate with that risk, no claims or guarantees are made. The statements and opinions contained in this handbook are from research and personal experience of the author.⁴

^{4 Includes references to financial ratios, formulas and terminology commonly used in the credit industry.
This handbook includes references to government regulatory agencies published material}

1. Rating Credit Risk ↑top

How a financial institution selects systems and manages its credit risk is critically important to its performance over time. Identifying and rating credit risk is essential to managing performance. Regulators expect financial institutions to have credit risk management systems that accurately analyze risk. A financial institutions risk rating system should reflect the complexity of its lending activities and overall level of risk. Ratings should be regularly tested for accuracy, and credit quality independently assessed. Using expert models and systems supports appropriate internal analysis. Risk ratings must be accurate and timely.

2. Functions of Credit Risk Rating Systems ↑top

Informed decision making and optimizing returns are the main functions of a credit risk rating system. A proven system promotes consistent underwriting and credit approval, which allows stable growth and profitability. Risk rating systems should be independently validated regularly.

The system should be a cornerstone for credit risk management, ongoing monitoring, and reporting to management. The Board should approve the process and receive sufficient data to oversee credit risk management. Every credit should be rated and tracked by risk rating, industry type and collateral type. Portfolio distribution should be periodically monitored and reasonably compare with Board approved standards.

Risk on individual credits and risk on portfolios change over time. A well-designed system will track trends for early detection of improving risk as well as potential problems. SuretyScore^sm utilizes two places behind the decimal to track trends because a 4.90 – Acceptable credit has a higher risk than a 4.10 – Acceptable credit. Both are 4’s – Acceptable, but the digits behind the decimal identify the truer lending risk. A well-designed system helps document loan and credit files. A well-designed system helps minimize losses and maintain ALLL levels. A well-designed system weighting is essential to match rating definitions. SuretyScore^sm matches the following definitions and ratings:

1. Superior = Excellent business credit. Major firm with superior asset quality. Excellent management, debt capacity and coverage, excellent access to alternate credit sources. Loan secured by properly margined liquid collateral.

2. Excellent = Above average business credit. Significantly respected firm. Very good management. Very good asset quality and liquidity, strong debt capacity and coverage. Excellent access to alternate credit sources.

3. Satisfactory = Average business credit. Highly respected firm. Good management. Good asset quality and liquidity with excess debt capacity and coverage. Very good access to alternate credit sources.

4. Acceptable = Acceptable business credit. Respected, established firm. Good management. Satisfactory asset quality with little excess liquidity. Acceptable debt capacity, though nearly full leverage. Loans may require structuring with adequate covenants. Good access to alternate credit sources.

5. Marginal = Marginally acceptable business credit. May exhibit some management weaknesses. Generally acceptable asset quality with strained liquidity. Fully leveraged with little or no excess debt capacity. Loans may require more stringent covenant structuring and close monitoring. Some access to alternate credit sources.

6. Special Mention = Marginally acceptable business credit with potential or recently occurring weakness. Management is strained, but capable of redirection. Asset quality is questionable, liquidity is inadequate. May be over leveraged. No loss is envisioned, but close and constant monitoring is required. Limited or no access to alternate credit sources.

7. Substandard = Unacceptable business credit.Normal repayment is in jeopardy. Asset quality is inadequate. While no loss is envisioned, there are weaknesses that may impact collection of debt. There is inadequate risk capital. Repayment capacity and the value of collateral may be inadequate to satisfy the debt.

8. Doubtful = Full repayment of principal and interest is doubtful. Serious problems exist such that partial loss of principal is likely.

9. Loss = Anticipated total loss.Loan is uncollectible or has little discernable value. Recovery cannot be estimated in the foreseeable future.

3. Use of SuretyScore^sm for Commercial Loans ↑top

Business owners typically handle their business finances the same as their personal finances.As such, business owner(s)/Guarantor(s) Character is the baseline for establishing risk. The components of measuring Character include Guarantor Credit Score, Management Qualifications and Experience, Quality of Business Financials and Quality of Guarantor Financials. Sometimes business and personal finances are so entwined it is difficult to distinguish between the two. Regardless, Character can be quantified to indicate a risk score for the reliability of the person or persons behind the business. Payment history and organized financials are key markers. Management qualifications should be more than years of experience. It should also include lender observations and “feel”.

A. Measuring Character and Management Quality ↑top

1. Guarantor Credit Score – personal credit scores over 700 are strengths. Scores below 650 may be a weakness.

2. Management Experience – Over 11 years of management experience is a strength, whereas less than 3 years experience is a weakness.

3. Quality of Business Financials – Business owners that do not present the latest available financials probably do not know their numbers. Does not matter if professionally prepared or company prepared, tax returns should include all schedules, and a balance sheet(s) and income statement(s) should be provided covering the period since the last tax return. The latest data that can be verified is a strength. Companies that file tax return extensions or offer stale data could be signs of potential weakness.

4. Quality of Guarantor Financials – Tax returns and personal financial statements should include schedules. Schedules provide insight and support numbers. Good, verifiable data is a strength. Incomplete tax returns or personal financial statements without schedules are signs of potential weakness.

Management quality weighted at 30%.

B. Measuring Capacity ↑top

Capacity is where the rubber hits the road! What do finances look like after taking on new debt? Is there a good balance of borrowed funds versus business revenue and capital used in operations?

1. Debt Service Coverage Ratio – Does the business produce enough cash to pay all obligations? How many dollars of cash flow are available for every dollar of debt including lease payments? A healthy ratio is 1.25:1 or greater.Meaning $1.25 is available from cash flow for every $1.00 of debt and lease payments. Between 1.25:1 to 1.10:1 is generally acceptable, but is not a strength nor weakness. This is considered a “gray” area that may require the lender to better understand the timing of cash flow available versus due date of payments. DSCR below 1:10:1 is a weakness. Typically, DSC is measured globally by considering cash from all sources and debt of the borrowing business, related companies, and guarantors/principals.SuretyScore^sm shows DSCR as it is before the new loan and the new DSCR if the loan is made. If income is projected to be generated from loan proceeds, figure DSCR with and without projected income. A good lender understands projected income is hypothetical and should be qualified before using in DSCR.

2. Guarantor Debt to Income – Industry standard is 43% or less personal debt payments compared to personal gross income. Below 26% is a strength. On commercial loans, contingent liabilities for the business owner(s) may push DTI over 43%. It is wise to understand the effect of contingent liabilities on DTI.

3. Debt to Equity – How much credit does the business use compared to cash from operations? Total company debt less than 2 times equity is strong. Between 2 and 3 times equity is satisfactory. Between 3 to 4.50 times equity is acceptable however, reasons for debt need to be understood to avoid potential weakness. Debt over 4.50 times equity is a weakness.

Capacity and Leverage weighted at 25%

C. Measuring Working Capital and Liquidity ↑top

What does a business have on hand for daily operations? What do they have to fall back on? Working Capital and Liquidity are generated by profit and indicate of how much cash is available to meet short term obligations and expenses. Working Capital is typically cash on hand from operations. Global Liquidity is the accumulation of cash for future use. Working Capital and Liquidity are often interwoven.

1. Global Liquidity – How much cash or readily convertible assets to cash are available to fund business operations and service debt? Most companies and owners have 5-20% cash compared to total assets. Anything above 20% is strong! Liquidity less than 10% of total assets may be a potential weakness.

2. Quick Ratio – Of all working capital measurements, this is likely the most conservative calculation showing how a company will pay short-term debts using only cash or cash equivalents. How many dollars of liquid assets are available to cover each dollar due in current liabilities? There is no hard and fast rule for a good quick ratio. Generally speaking, a 1.00:1.00 ratio is considered acceptable. From a lender’s perspective, more than 1.50 is healthy. A very high Quick Ratio may not be better. Why? It could be a sign the owners are not balancing short-term cash requirements and spending capital for long-term gains. Between .68 and .99 is a weakness. Ratios below .67 means the company can only pay 2/3 of its current obligations.

3. Interest Coverage – Leverage can be highlighted by comparing cash flow to interest owed on long-term obligations. Dividing a company’s profit by interest expense in a given period shows how a company can pay interest on outstanding debt. Is this 1.50 or higher? Above 3.50 is a strength.Below 2.00 is a potential weakness.

4. Secondary Sources of Repayment – Global Liquidity, Quick Ratio and Interest Coverage give lenders a solid assessment of a company’s capacity to pay current liabilities without selling inventory or assets, discounting accounts receivable, and stop pre-paying expenses such as rent, taxes and insurance. It also shows how likely they might be to struggle paying all debts. If things work out as planned by the borrower and lender, Secondary Sources of Repayment do not matter, but a prudent lender considers alternate credit access and other sources of income to get a true and complete financial picture. Recognizing solutions before they become needs helps in situations where a company has an interruption in cash flow.

Working Capital and Liquidity weighted at 25%

D. Collateral Type and Coverage ↑top

Collateral is pledged to a lender as a guarantee of repayment.If all else fails and the loan defaults, the lender liquidates collateral to recover losses.

Collateral Type and Coverage – Any asset important to operating a business can be considered collateral. Assets not owned by the business can also be used as collateral on a business loan. Liquid collateral at less than 90% loan to value (LTV) is most desirable, followed by a first mortgage on owner occupied commercial property or first mortgage on the business owner’s primary residence at less than 80% LTV. Titled liens, equipment liens and first mortgages on non-owner occupied or unimproved property are suitable collateral at reasonable LTVs. The weakest collateral is unsecured loans, credit cards and unperfected liens.

Collateral and Collateral Coverage weighted at 20%

E. External Factors and Other Considerations ↑top

External Factors and other considerations – State of the economy, industry trends and pending legislative changes may impact lender’s risk. These conditions are considered as to how they might affect loan repayment, both positively and negatively.

External Factors can add or subtract up to 30 basis points to the weighted items.

Loan renewals bring a new set of considerations. Adverse changes in asset quality, excessive revolving or line of credit balances, unsatisfactory collateral reviews, slow pay history and non-compliance with loan agreement are factored in to the updated risk rating for renewals.

Renewal considerations can add 25-50 basis points.

F. Identifying Strengths and Weaknesses ↑top

SuretyScore^sm provides a visual – strengths are highlighted with a green dot, weaknesses with a red dot. Instantly recognize the strengths and weaknesses of the credit and associated scores. Weighting and scores are proprietary to Credit Risk Surety, LLC. While any one category by itself does not determine risk, collectively all factors identify overall risk quantified by SuretyScore^sm.

G. Interpreting Analysis for Decision Making and Pricing ↑top

Interpreting SuretyScore^sm requires a basic understanding of the numbers behind the score and the source of those numbers. Although company prepared balance sheets and income statements (P&Ls) are indispensable for the latest data, tax returns are the most reliable. There can be a stark difference analyzing company prepared statements versus the latest tax returns – both business and personal tax returns. True, tax returns show taxable income rather than profit, but realistic cash flow can be ascertained with tax return data. Furthermore, Schedule L on business tax returns presents assets, liabilities and equity that can be proven. The consistent use of tax returns promotes consistency in each risk rating analysis. Interpretation also requires a solid business lending policy.

By using data from a consistent source like tax returns and a board approved lending policy, pricing can be established to meet strategic goals for income. A 2–Excellent rated credit interest rate should be discounted more than a 4–Acceptable rated credit as an example. A well-managed risk rating system can also outline a tiered origination fee structure based on risk rating.

H. Formulas ↑top

Debt Service Coverage Ratio

Global Cash Flow / Global Annual Debt Service

Debt to Income

Guarantor Annual Debt Service / Guarantor Gross Income

Debt to Equity

Borrower Total Liabilities / Borrower Equity

Global Liquidity

Global Cash / Global Total Assets

Quick Ratio

(Borrower Cash + Borrower Accounts Receivable)

Borrower Current Liabilities

Interest Coverage

(Borrower Net Income Before Taxes + Borrower Interest Expense)

Borrower Interest Expense

Collateral LTV

Collateral Value / (Loan Amount + Other Superior Liens)

Debt Service Coverage After Loan

Global Cash Flow / Global Annual Debt Service Including Estimated New Loan Payment

4. Use of SuretyScore^sm for Church Loans ↑top

Underwriting Church loans is very different from underwriting large commercial loans. Yet, commercial lenders tend to rely on risk rating models for business loans to determine risk for Church loans. There are some similarities like debt service coverage, debt to equity and collateral coverage, but there are also some glaring differences. Churches have Clergy and lay-leaders, but they are not the same as business owners. Business owners typically guaranty company debt. Church loans do not usually have personal guarantors. Churches use budgets, usually approved annually, while businesses use budgets, projections, balance sheets, income statements or P&Ls, and tax returns. Churches manage projects and sometimes rely on capital campaigns to fund projects, whereas business owners have capital and owner equity for capital[PT1] improvements and purchases outside normal cash flow. Global liquidity and working capital for Churches are measured by cash on hand compared to average expenses per day. Business owners use cash and accounts receivable for working capital, and liquidity can be assessed by considering business account balances and the owner’s personal account balances. SuretyScore^sm for Church loans uniquely analyzes components of organization quality, capacity, liquidity, collateral, and conditions.

A. Measuring Organization Quality ↑top

Organization Quality is the character of the Church. Do they make payments on time? How long have they been in existence? Are their Pastor and leaders stable? Are their financials presented in an organized, easy to follow manner?

1. Years in Existence – Over 25 years is a strength and less than 5 years is a weakness. A good lender not only considers this number, they will also consider how the Church is viewed in the community.

2. Pastor Stability – People become members of a Church for many reasons. Notably, the common religious and social bond they have with others, but more importantly, the emotional bond they have with the Pastor. Pastors ministering over 10 years at the same Church is a strength, less than 4 years is a weakness.

3. Quality of Financials – Lenders will see Church financials in many forms. There are some accounting standards used by Churches, but formats to report finances vary from Church to Church. Although rare, professional prepared balance sheets and income statements are the highest quality. Sadly, some Churches use bank statements to report income (deposits made) and expenses (checks issued). At the least, lenders should request current year budget and previous year budget with actual numbers.

Organization Quality weighted at 25%

B. Measuring Capacity ↑top

The ability of Churches to pay bills and debt is entirely dependent on member stability and giving. Church capacity should be quantified exclusively with receipts from member giving. Capital campaigns, one-time donations, grants, and the like are not stable sources of revenue and should be thought of as secondary sources of repayment.

1. Debt Service Coverage – Unlike business financials that indicate owner’s equity, Church budgets show income from all sources, all expenses and reserves or cash balances on hand at a point in time. Expenses can be generally broken down into these categories: Administrative, Personnel, Building and Discretionary. Churches often organize capital campaigns or fundraisers for projects. Pledges in capital campaigns are not the same as cash and not recurring income. Does the Church receive enough cash from regular, recurring member giving to pay all obligations? What cash does the Church spend on discretionary items? Typically, debt service coverage is figured by considering cash from regular member giving plus 50% of discretionary expenses compared to Church debt. Is this 1.10 or higher? Does the timing of cash received match cash paid on debt and expenses? If no to these questions, cash may not be sufficient to service new debt. A healthy ratio is 1.25:1 or greater. Meaning $1.25 is available from cash flow for every $1.00 of debt and lease payments. Between 1.25:1 to 1.10:1 is generally acceptable, but is not a strength nor weakness. This is considered a “gray” area that may require the lender to better understand the timing of cash flow available versus due date of payments. DSCR below 1:10:1 is a weakness.

2. Annual Revenue per Giving Unit – Churches usually report the total number of members and number of families. A family is not necessarily a giving unit.Conversely, sometimes there is more than one giving unit in each family. If a Church cannot confirm the number of giving units, the rule of thumb is to divide the total number of members by 2.5 to reasonably estimate giving units. How much cash does the Church receive on average from each giving unit annually? Anything over $1,500 is a strength.Below $800 is a weakness and may be an indicator of limited borrowing capacity.

3. Total Debt per Giving Unit – How much does the annual debt payments of the Church break down for each giving unit? Under $2,000 is a strength. Greater than $3,750 may be an indicator the Church is obligated beyond the means of Church members.

4. Total Debt to Annual Revenue – The ratio of total debt to annual revenue illustrates if the Church is leveraged with debt. A Church leveraged with debt must cut expenses for ministries, administration, buildings, and discretionary items. Less than 2.5 times is a strength. Over 3.75 times is a weakness.

Capacity weighted at 30%

C. Measuring Liquidity ↑top

Church financials should always include balances in bank accounts. This shows the cash on hand. However, Churches that report budget reserves show diligence in building cash on hand.

Liquidity measures cash for expenses and projects. Good lenders also examine sources of repayment other than regular giving and cash on hand.

1. Liquidity per Expense Days – How many days can the Church pay expenses with the cash on hand? Over 180 days is a strength, while less than 90 days is a weakness.

2. Cash in Project – If a Church applies for a capital improvement project, there are some thresholds that should be recognized. More than 30% cash set aside specifically for the project is a strength. Less than 10% cash to help fund the project is a weakness. For perspective, well-managed Churches have 50% cash on hand for projects and borrow 50%. These same values can apply to down payments on vehicles. Capital campaigns and fundraising drives are commonly used to accumulate funds. Important to remember – capital campaign pledges are not the same as cash on hand!

3. Secondary Sources of Repayment – Compensating balances on deposit with your institution and alternate credit access are good signs of fallback positions should Church plans not work out as expected. This is by no means an exit strategy, but liquidity in a Church helps avoid troubled loan situations. Deposits over 50% of the loan amount is a strength. A Church relying on capital campaigns or donors for repayment is a weakness.

Liquidity weighted at 25%

D. Collateral Type and Coverage ↑top

Collateral is pledged to a lender as a guarantee of repayment. If all else fails and the loan defaults, the lender liquidates collateral to recover losses. Church real property pledged as collateral may not have the same marketability as other commercial property. Church real estate is specialized and would require a specialized buyer in the event of foreclosure.

Collateral Type and Coverage – Liquid collateral at less than 90% loan to value (LTV) is most desirable, followed by a first mortgage on Church real property or first mortgage on Church land. Titled liens on Church vehicles bring average risk. The weakest collateral is unsecured loans, credit cards and unperfected liens. Less than 80% LTV is generally a strength.Over 80% is a weakness.

Collateral weighted at 20%

E. External Factors and Other Considerations ↑top

External Factors and other considerations – State of the economy, state of Church membership and renewal considerations may impact lender’s risk. These conditions are analyzed as to how they might affect loan repayment, both positively and negatively.

External Factors can add or subtract up to 20 basis points to the weighted items.

Renewal considerations can add 25-50 basis points.

F. Identifying Strengths and Weaknesses ↑top

SuretyScore^sm for Churches provides a visual – strengths are highlighted with a green dot, weaknesses with a red dot. Instantly recognize the strengths and weaknesses of the credit and associated scores. Weighting and scores are proprietary to Credit Risk Surety, LLC. While any one category by itself does not determine risk, collectively all factors identify overall risk quantified by SuretyScore^sm for Churches.

G. Interpreting Analysis for Decision Making and Pricing ↑top

Interpreting SuretyScore^sm for Churches requires a basic understanding of the numbers behind the score and the source of those numbers. Few Churches provide professionally prepared financials. Most Churches furnish in-house produced budgets that come in a variety of formats. Separating expenses into categories should always be done by the loan officer or underwriter to get consistency from one Church budget to another. However, the basics are all the same – income is received from members and expenses can be grouped in the following categories:

Administrative Expenses – Expenses important to Church operations. Examples: office supplies and literature, publications and bulletins, missions and ministries, evangelism and transportation services (bus/van).

Personnel Expenses – Staff compensation, payroll taxes, insurance and professional development.

Building Expenses – Building and equipment maintenance, janitorial and kitchen supplies, utilities and insurance.

Discretionary Expenses – Budgeted items not necessary for administrative, personnel and building expenses. Examples: supplemental choirs and instrumentals, banquets and fellowships, guest speakers and staff gifts, purchase of new equipment and miscellaneous supplies.

H.Formulas ↑top

Debt Service Coverage Ratio

Global Cash Flow / Global Annual Debt Service

Annual Revenue per Giving Unit

Annual Revenue/Giving Unit

Total Debt per Giving Unit

Total Debt/Giving Unit

Total Debt to Annual Revenue

Total Debt/Annual Revenue

Liquidity per Expense Days

Total Expenses/365 = Expense Days

Cash on Hand/Expense Days

Collateral LTV

Collateral Value / (Loan Amount + Other Superior Liens)

Debt Service Coverage After Loan

Global Cash Flow / Global Annual Debt Service Including Estimated New Loan Payment

5. Risk Based Lending Best Practices ↑top

Use an underwriting checklist. An organized loan file adds credibility with examiners and regulators. A checklist proves underwriting diligence and lending integrity.

Follow loan policy. A well-designed policy will match regulations. At a minimum, policies should be reviewed and approved by the Board annually. SuretyScore^sm is a well-designed program matched to regulations and meant to compliment loan policy.

Trust your instincts. A seasoned underwriter and lender always gets a feel for the circumstances surrounding each transaction. Decision making for a good lender requires a balance of understanding the numbers and having an intuitive feel for everything not accounted for in the risk rating. A good practice is to meet with a business owner in their place of business. The sights and sounds in the business help a good lender get a feel for the credit.

Recognize the obvious. It is okay to be skeptical! Being skeptical keeps a good lender from overlooking tangible pieces of the overall picture. The most obvious – how likely is repayment?

Be consistent in decision making. A conservative approach to lending is prudent. With a good lender, a predictable pattern of approve, deny, and condition decisions becomes evident. The keys are the lender’s thought processes and how the lender documents those thoughts.

Use reliable risk rating tools. Risk ratings are used in every financial institution. There are many methodologies in administering risk rating systems. How can a lender be confident ratings are accurate for the risk and pricing of individual loans? How can a management be certain ratings are accurate for the global risk and profitability of a portfolio? The best gauge for the effectiveness of a rating system is past due and charge off ratios compared to peer institutions. Be sure with SuretyScore^sm.

Use loan covenants. Covenants are used in loan documentation to mitigate risk. For example, assignment of a life insurance policy may be required on a business owner. Why? Because repayment will be in jeopardy if the owner dies. Another good example is limiting a business owner’s earnings to income reported on tax returns. Why? Because repayment may be compromised if the owner is taking distributions over income generated for the period. These are just a few examples, but bottom line is covenants help mitigate risk. Covenants do not make a marginal loan or bad loan better.

Communicate with management and the Board of Directors. Open communication from underwriters and lenders to management and Board supports strong portfolio management. Combined with SuretyScore^sm, management can differentiate credit risk, detect deterioration of credit quality before it becomes a problem, control concentrations of credit in industries/business types, and establish appropriate ALLL levels.